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Should You Get Defensive with Defense Stocks?

March 27, 2017, 3:39 pm

It’s no surprise this industry has been on the top of investors’ minds given how long it’s been in the headlines. Not only did President Trump promise to build up the military while on the campaign trail, he proposed a “historic” increase in defense spending of $54 billion, bringing the Pentagon budget to a whopping $603 billion, during his first speech to Congress. Despite all this, I do not see a lot of growth investing opportunities here.

Due to budgetary restrictions imposed by the Budget Control Act of 2011, as well as the need to spend more on Social Security and Medicare as the population ages, there’s not much room for long-term defense spending growth. Even President Trump’s much talked about 10% increase in defense spending in the September 2018 fiscal year would only put Department of Defense expenditures back to 2007 levels, when spending declined as the Iraq war wound down.

In addition, there’s no guarantee that the president will get the increase he’s asking for, with even some Republicans uncomfortable with the amount of non-defense spending cuts that would be required to fund the additional budget. Barring another major war, I do not expect to see consistent long-term spending gains drive revenue growth for defense contracts.

The pure-play defense stocks are dominated by a few large names: Lockheed Martin (LMT), General Dynamics (GD), Raytheon (RTN) and Northrop Grumman (NOC). Top-line growth for these companies has been minimal the past several years due to lackluster defense budgets. And yet, the stocks have actually done well, with share prices more than tripling over the past five years. These names have used the low interest rate environment to aggressively buy back stock, with earnings also benefitting from margin expansion. However, engineering growth this way is not sustainable, and with the shares now trading around 20X this year’s earnings estimates, I don’t see significant upside in them over the next 12 months.

In fact, LMT, RTN and NOC have lagged the market considerably after rallying the day after the election. While GD has beaten this trend with strong margin performance in the fourth quarter, I believe the recent underperformance of the group as a whole is a “tell” that the great five-year run the stocks have been on will not repeat itself. The industry is more likely to not see meaningful earnings increases from incremental defense spending, or it at least has already been discounted into the stock price.

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